Krugman Against Ferguson: What Do Rising Treasury Yields Really Mean?

The debate currently raging between Paul Krugman and Niall Ferguson pits traditionalists who think rising yields signal rising investor confidence against declinists who think yields are rising because the US is trashing its currency by monetizing debt. Unfortunately, both men may be basing their arguments on outdated metrics that don’t take into account the radical changes we’ve wrought in the way our economy operates.

Under the traditional view, a rise in treasury yields—which means prices are going lower because demand is shrinking—signals an economic recovery. It means investors aren’t just fleeing to the safety of government bonds. Instead, investors are willing to reach for a few more points of potential gain than the couple of points of interest they get with treasuries. In the current situation, this view would hold that the rise in treasury is evidence of confidence in the economy and a return to normal market functionality.

That’s basically the view taken by Paul Krugman, the very sharp Nobel prize winning economist with whom we’ve found so much to agree on when it comes to the bailout of troubled financial institutions. Certainly, Krugman’s view is supported by the everyday sentiment of ordinary people and the behaviour of the stock market recently. Consumer confidence has been on the rise, panic has subsided, weak bank stocks have rallied tremendously and, anecdotally, people we run into in saloons and dinner parties seem less fretful about an imminent economic collapse.

Ferguson argues that the traditional view taken up by Krugman is wrong. As he sees it, the market is pricing troubled times ahead for the US government. The huge debt issued is effectively being monetized, and much more of this is likely in the future. The yields are rising in anticipation of inflation, Ferguson writes. He’s got the lessons of the economic titans of the past who went down this road to support the declinist position.

We won’t really know who is right for quite some time. Unfortunately, without a crystal ball to tell us the future, there’s no final way of resolving this debate until actual events unfold. But we think both positions overstate the value of looking at the market for treasuries to indicate future economic performance.

We’ve mentioned this before (here and here) but it bears mentioning again: we’ve broken the credit markets. Where once we could learn a lot about investor sentiment and expectations from the credit markets—including the markets for treasuries—the signaling function now is by and large useless. That’s because there are now way too many debt instruments that are the functional equivalent of treasuries. We have a lot of bank debt floating around that is backed by the FDIC explicitly, for example. And even the new debt that banks are issuing without explicit government guarantees is backed by a semi-explicit guarantee voiced by politicians who have promised “no more Lehmans.” In other words, every large, complex systemically important financial institution is a government sponsored entity these days. Why buy treasuries when you get a better return from bank debt that is just as safe? In short, the short term fluctuations in treasury yields now result from way more factors than they once did, and the signals about market expectations they through off are far less transparent.

What should investors make of this? We think the lesson to be drawn is one of caution. You should probably heavily discount the advice of anyone insisting that traditional measures will be good indicators under our dramatically different financial landscape. Ironically, however, enough investors may be stuck in the old models to make these signals work as a sort of misleading feedback loop in the short term. To put it differently, if enough investors irrationally believe that the rise in treasury yields signals an economic recovery the traditional asset classes that rise in connection with that kind of anticipation will probably rise. Shorts can be badly hurt by underestimating this investor confidence feedback effect. As they say, the markets can stay irrational longer than you can stay solvent.

Treasury prices today, with the yield curve flattening, seem to be anticipating a rise in interest rates, perhaps by as early as the end of year. More generally, the Krugman side of the debate seems to rest on the faith that the Fed and Treasury will know exactly when to reverse monetary (zero interst rates) and fiscal (stimuls) policy to avoid undesirable levels of inflation. Ferguson is a sceptic on this count.

Our own position, as we said, is that there’s just too much noise to detect a signal from these once valuable market processes.